Share Buybacks That Precede Disaster

by Jeff BaileySeptember 08, 2010

The BP oil spill in the Gulf of Mexico left the British oil giant scrambling to raise cash and ensure its liquidity, after 11 deaths and hundreds of miles of fouled beaches raised the prospect of tens of billions of dollars of liability. BP took a $32.2 billion second quarter charge related to the April 20 explosion that sunk the Deepwater Horizon rig.

BP halted its dividend payout, savings $10 billion a year. And BP on July 20 agreed to sell some assets to Apache Corp (APA). for $7 billion and said it hopes to sell another $23 billion of properties. As YCharts reported, it appears BP will weather the storm.

But BP shareholders would be right to suspect that a desperate seller won’t necessarily get top price for the assets it’s selling. Borrowing will grow more costly, as BP’s credit ratings were downgraded and credit default swaps covering its debt traded at widened spreads.

What’s more, regardless of who’s to blame for the Deepwater platform’s sinking, BP is responsible for its own balance sheet. And, as Bloomberg BusinessWeek noted, BP’s liquidity crunch was made even worse by the $37 billion it spent buying back its own shares in recent years, at what now seem highly inflated prices.

BP is far from alone. Prior to the financial collapse, companies in the Standard & Poor’s 500 during an approximately four-year period spent $1.78 trillion buying their own shares. That collectively weakened the balance sheet of the U.S. corporate sector and was among the reasons the market collapse hit the economy so hard. Most troubling, some of the big financial companies that needed government support to get through the crisis were among the biggest buyers of their own stock.

So, in the fall of 2008, Morgan and Goldman each took $10 billion in federal support, Citigroup received a staggering $45 billion, and GE had to sign up for emergency federal programs to backstop its liquidity.

Citigroup made most of its buybacks in the $40s and $50s; its stock is at less than $4 now.

At the depth of the crisis, GE and Goldman had to pay Berkshire Hathaway (BRK.A) chairman Warren Buffett a 10% preferred stock dividend to attract a combined $8 billion from the Omaha investor, far above their normal borrowing cost. Buffett also extracted a big slug of warrants from each company, a further penalty.

It was as if Buffett was waiting for them to call. In his letter to shareholders in March 2000, he’d engaged in a genteel tirade against buybacks. “Buying dollars for $1.10 is not good business,” he wrote. “Repurchases are all the rage but are too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price.”

Buffett returned to the topic in his 2006 letter, as buybacks were accelerating at U.S. companies, spinning a yarn about “Fred Futile, CEO of Stagnant Inc.,” a man loaded up with stock options and furiously buying back his company’s shares – a description that applied to hundreds of CEOs. The buybacks reduce the shares outstanding, in Buffett’s telling, sending Fred’s options soaring even as Stagnant’s profits slide sideways.

Dividends, another way to give cash to shareholders, aren’t nearly as helpful to the options-laden CEO, Buffett noted. Not surprisingly, dividend payouts have lagged far behind buybacks.

Buybacks among S&P 500 companies were $137.6 billion last year, way down from the 2007 peak of $589.1 billion, S&P says. But the repurchases will return. Once the economy and stock market start humming again, buybacks will rise. Until pay for CEOs is tied to judicious fiscal behavior instead of boosting earnings per share at any cost, chief executives will continue to swing for the fences.

Here, you can see recent buyback activity by major companies. Click on the dollar figure for a particular company and you’ll see its buyback history. Then click on “see overview for Company Name” and you’ll see the full YCharts report, including cash on hand. That’s an important number for a company buying back its shares.

On the buybacks list, it’s hard to say whose drilling platform might explode, or whose market might implode, though energy and finance companies are well-represented on the list. And even Goldman Sachs was again buying its shares earlier this year.